Dark pools, HFT and the trading world private investors never see

Most private investors picture the stock market as a single, visible place where buyers and sellers meet, prices tick up and down on a screen, and a click on a broker’s app sends an order off to be matched in the open. That picture is comforting. It is also, in most cases, wrong. A great deal of share trading in the United Kingdom now happens away from the lit exchanges altogether, in venues that do not display orders before they are filled and through systems built to act in microseconds. None of this is illegal. None of it was designed with the small investor in mind either.

The first piece of this hidden infrastructure goes by a name that sounds like something out of a thriller. Dark pools are private trading venues run by investment banks, brokers and specialist operators, where large orders can be matched quietly, away from the order books that everyone else can see. The point is to avoid moving the price. If a fund manager wants to sell two million shares in a mid-cap stock, posting that order to the public market would send the price tumbling before half of it had been filled. Doing the same trade in a dark pool, against a counterparty who happens to want to buy, settles the matter without the rest of the market ever knowing it happened until the trade is reported afterwards.

The trade-off is transparency. Public markets work on the principle that anyone can see the orders waiting to be filled, which helps prices reflect available information. Dark pools weaken that principle. Regulators have been edgy about them for years. In Europe, MiFID II introduced caps on how much trading in any one share could happen in dark venues before they had to be temporarily switched off, and the FCA has continued to police those caps in the UK after Brexit. The rules push more flow back onto lit exchanges or onto a category called systematic internalisers, where banks match client orders against their own books with stricter reporting obligations.

High-frequency trading sits alongside the dark pools but does its work on the lit exchanges, in the spaces too small for human hands. A high-frequency firm uses low-latency networks, co-located servers and algorithms to react to price movements in microseconds. Some of what these firms do is recognisable as market making, posting bids and offers and earning the spread in return for providing liquidity. Some of it is arbitrage, exploiting tiny price differences between venues. A more controversial portion is sometimes called latency arbitrage, where the firm uses its speed advantage to get in front of slower orders and trade ahead of them.

The argument in favour of high-frequency trading is that it has narrowed bid-ask spreads on big, liquid stocks and increased the depth of the order book at the top. The argument against is that the liquidity it provides is shallow and disappears in a crisis, and that ordinary investors pay an invisible toll to firms whose only edge is being a few milliseconds quicker. Both arguments have evidence behind them. The honest answer for a private investor is that a buy or sell order in a household name like Vodafone or AstraZeneca probably gets filled at a slightly tighter spread because of these firms, while the same firms are taking small slices out of orders all day long without anyone noticing.

The episode that brought all this into public view was the Flash Crash of 6 May 2010, when the Dow Jones fell roughly nine per cent in a matter of minutes and recovered most of the move just as quickly. A combination of a large algorithmic sell order, the withdrawal of high-frequency liquidity providers and feedback loops between venues sent prices into freefall before circuit breakers and human traders restored some order. Investigations afterwards led to the eventual prosecution of a London-based futures trader for spoofing, and more importantly to a series of regulatory changes including kill switches, tighter circuit breakers and pre-trade risk controls. Smaller flash events have happened since, in equities, currencies and even sovereign bonds. The infrastructure is faster but it is also more fragile.

Beyond the headline categories sit the proprietary trading desks and the inter-dealer brokers. Proprietary trading describes a bank or specialist firm putting its own capital at risk in the markets, distinct from executing client orders. Some of the largest investment banks scaled back their proprietary trading after the post-2008 reforms in the United States, but the activity migrated rather than disappeared. Specialist firms, principal trading firms and the trading arms of hedge funds picked up the work. Inter-dealer brokers, meanwhile, are the wholesalers of the market. Names such as TP ICAP and BGC Partners sit between the big banks, finding the other side of large trades in bonds, swaps and currencies that would never sit comfortably on a public order book.

None of this is visible to a private investor putting in a modest order through an online broker. The order flows through a chain that may include the broker’s own internal matching engine, a systematic internaliser run by a market maker, one or more lit exchanges and possibly a dark pool, before settling at a price that, on a quiet day in a liquid stock, is probably very close to what the screen showed at the moment of the click. That last point is the practical takeaway. The infrastructure is dauntingly complex, and it is reasonable to feel a little uneasy about the parts of it that operate in the dark, but for someone trading liquid UK shares in sensible size the system mostly works. The wider the spread, the smaller the company and the more illiquid the market, the more the hidden machinery starts to bite.

The right defence is not to try to outmanoeuvre the high-frequency firms, which is not a contest a private investor can win. It is to use limit orders rather than market orders for any trade that matters, to be wary of trading thinly traded shares in a hurry, and to remember that the price on the screen is a snapshot of what happened a moment ago, not a guarantee of what is about to happen. The professional traders sitting between the buyer and the seller make their living from the gap between those two things.

Photo by AlphaTradeZone via Pexels.

Street Smart is a series drawn from first-hand experience of the City of London, updated as each new chapter arrives.

This post is drawn from The Street-Smart Trader by Ian Lyall. Republished with permission.

Disclaimer: The value of investments can go down as well as up, and you may get back less than you invest. This article is for informational and educational purposes only and does not constitute financial advice. Always do your own research and consider seeking independent advice before making any investment decision.

This article is for informational purposes only and does not constitute financial advice. Investment values can go down as well as up. Always do your own research before making any financial decisions.